Introduction to call ratio backspread
Bullish traders, or traders anticipating an upward trend in the market, use a call ratio backspread, whereas bearish traders – who anticipate a downward movement in stock prices – will usually go with a put ratio backspread.
In case you are a beginner trader, do wrap your head around these two concepts before reading ahead.
As some of you might already know, in a call option, the holder of the contract possesses the right to demand sale of shares at the strike price specified in the contract. However the contract holder is not obligated to buy. The reverse is true for a put option, but that concept is more relevant to put ratio backspread.
In trading, your positions can be long or short – when you buy stocks (or any other asset) and aim to sell them at a higher price, you are trading long. When you borrow stocks, sell them and aim to buy them back at a lower price, you are trading short.
How call ratio backspread trading works
The trader will sell one call and with the premium earned from that contract, he or she will buy several calls. The strike prices of the purchased calls will be different but the expiration dates will be exactly the same.
Fundamentals of call ratio backspread options
Ratio used: Most often traders go for a ratio of 1:2 or 2:3 or 1:3 where the former represents the short calls and the latter represents the long calls.
Strike price basics: The trader sells call option contracts that specify a lower strike price and buys call option contracts mentioning a higher strike price.
When to use a call ratio backspread: Both types of ratio backspreads are used in moments of stock price trend reversal. Though of course, a call ratio backspread will be used by a trader whose predictions indicate that the downtrend is going to reverse to an uptrend.
What’s the catch? Why would the other party agree? There is no catch; it’s more about opposing predictions being at work. A call option backspread and put option backspread (just like put options and call options) are simply two sides of the same coin. Contracts bearing the lower strike price only exist because there are bearish traders who believe that the price will fall even further.
What to expect: If the bullish trader’s predictions are proven correct, then the stock price will rise above the strike price of the call options that he or she has purchased.
Why employ this strategy: The goal of a call ratio backspread option is to help traders potentially maximise earnings if the stock price goes up, and to limit their potential losses if the stock price goes down instead.
Stock market example of how this strategy is implemented
The shares of P Pharma are currently trading at Rs 2000 per share.
Step 1: Mr T buys two call options contracts with a strike price of Rs 2000 at a premium of Rs 200. He gets 100 options in each contract so he spends Rs 200,000 per contract and Rs 400,000 in total. Plus Rs 400 on buying the contracts
Step 2: Mr T also writes/sells one call options contract which mentions a strike price of Rs 1800 per share of P Pharma. The premium for this contract is higher, Rs 600 and although it is negligible Mr T has made some nominal earnings of Rs 200 and has (technically) not spent anything to buy the options contract (because the amount he spent on the premium was more than offset by the amount he spent on premium).
Step 3: Mr T keeps an eye on the market and his expiration dates.
By expiry, the stock price rises to Rs 2500 per share.
Step 4: Mr T earns Rs 500 per share on the two contracts he bought. Multiply this by 200 (because of 2 contracts of 100 shares each). As a result, he earns Rs 10,000
Step 5: The contract holder he sold to also exercises his right and Mr T also has to sell his P Pharma shares at Rs 1800 per share against a Rs 2500 market price. He loses Rs 700 per share multiplied by 100 shares = Rs 7,000. That’s terrible, isn’t it? But wait! Mr T also earned Rs 10,000 from this strategy + Rs 200 from the premium difference. So he actually earned Rs 10,000 minus Rs 7,000 plus Rs 200 = Rs 3200.
Pros and cons of call option backspread
Call option backspread can be very beneficial to target earnings in a predicted upswing while protecting the trader if stock prices do fall.
That said, options trading is complex and represents double volatility which is volatility in both the stock price and the option price. This level of complexity calls for a good amount of stock market experience.
Stock market risk cannot be completely eliminated by this strategy or any other strategy. However, it can be substantially minimised, provided you know what you are doing.